CAPITAL STRUCTURE

(Source of Presentation: Financial Management by Dr. R.P.Rustagi; Financial management- Principles and Practice by Dr. S.N.Maeshwari)

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 LEARNING OUTCOME

S. No Learning Outcome PO Level

1. To understand the concept of PO1
capital structure.
2. To study the application of capital PO2
structure theories.

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 INTRODUCTION

Capital structure is essentially concerned with how the firm decides to divide its cash
flows into two broad components, a fixed component that is earmarked to meet the
obligations toward debt capital and a residual component that belongs to equity
shareholders” -P. Chandra
The capital structure is how a firm finances its overall operations and growth by using
different sources of funds. Capital structure may includes:

• Equity

• Preference shares

• Debentures

• Retained earnings

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 CAPITAL STRUCTURE VS. FINANCIAL
STRUCTURE

Point of Difference Capital Structure Financial Structure

Scope It is a narrow concept. It It is a wider concept. It includes
includes only long term both short term and long tern
sources of funds. sources of funds.
Core Content Long term capital is the core Capital structure is the core
content of capital structure. content of financial structure.
Financing of Composition of capital Current liabilities should not be
Current Assets structure can be used for used to finance acquisition of
acquisition of current assets. fixed assets.

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 CONTD…

Point of Capital Structure Financial Structure

Difference
Meaning The combination of long term The combination of long term and
sources of funds, which are raised by short term financing represents the
the business is known as Capital financial structure of the company.
Structure.
Appear on Balance Under the head Shareholders fund The whole equities and liabilities
Sheet and Non-current liabilities. side.
Includes Equity capital, preference capital, Equity capital, preference capital,
retained earnings, debentures, long retained earnings, debentures, long
term borrowings etc. term borrowings, account payable,
short term borrowings etc.
One in another The capital structure is a section of Financial structure includes capital
financial structure. structure.

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COMPOSITION OF CAPITAL STRUCTURE

• Debt and equity capital are used to fund a business‟ operations, capital expenditures, acquisitions, and
other investments. There are tradeoffs firms have to make when they decide whether to raise debt or
equity and managers will balance the two try and find the optimal capital structure. Thus the two main
sources through which company can make it‟s capital structure are:
– Ownership securities/ Capital

• Equity Shares

• Preference Shares

• Retained Earning

– Creditor ship Securities

• Debentures/Bonds

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 FACTORS DETERMINING CAPITAL
STRUCTURE

• Minimization of risk

• Control

• Flexibility

• Profitability

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PATTERNS OF CAPITAL STRUCTURE

• A company may begin with the simple type of capital structure i.e., by the issue of equity shares
only, but gradually this becomes a complex type, i.e., along with the issue of equity share, it may
make a financing-mix with debt.

 Equity capital only

 Preference capital only

 Debt only

 A mix of equity and debt capital.

 A mix of debt and preference capital.

 A mix of equity and preference capital.

 A mix of equity, preference and debt capital in different proportions.

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 OPTIMUM CAPITAL STRUCTURE

• Optimal capital structure is a financial measurement that firms use to determine the best mix of debt
and equity financing to use for operations and expansions. This structure seeks to lower the cost of
capital so that a firm is less dependent on creditors and more able to finance its core operations
through equity.

• Thus an optimum capital structure is one which:

 Maximizes the worth or value of the firm
 Minimizes the cost of capital
 Maximizes the benefit to the shareholders by giving best earning per share and maximum market
price of the shares in the long-run
 Is fair to employees, creditors and others.

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 FEATURES OF OPTIMUM CAPITAL
STRUCTURE

• Simplicity
• Profitability
• Solvency
• Flexibility
• Conservatism
• Control
• Optimal debt-equity mix
• Maximization of the value of the firm

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 CAPITAL STRUCTURE THEORIES

• The capital structure theories are facilitating the business fleeces to identify the optimum capital
structure. The optimum capital structure of the organization differs from one approach to another due
the assumption which are underlying with reference to many factors of influence. The success of the
firm is normally depending upon the rate at which the financial resources are raised, differs from one
organization to another depends upon the needs. The cost of capital is having greater influence on
the EBIT level of the firm; which directs affects the amount of earnings available to the investors,
that finally reflects on the value of the firm. The following are the various capital structure theories:

(i) Net income approach

(ii) Net operating income approach

(iii) Modigliani and Miller approach

(iv) Traditional approach

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ASSUMPTIONS OF CAPITAL STRUCTURE
THEORIES

(i) There are only two resources in the capital structure viz Debt and Equity share
capital

(ii) The dividend pay out ration 100% which means that there is no scope for the
retained earnings

(iii) The life of the firm is perpetual

(iv) The total assets of the firm do not change

(v) The total financing remains constant through balancing taking place in
between the debt and share capital

(vi) No corporate taxes; this was removed later

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 NET INCOME APPROACH

• Net income approach was developed by Durand, in this he has portrayed the influence of the leverage on the value of the
firm, which means that the value of the firm is subject to the application of debt i.e., leverage. In this approach, the cost of
debt is identified as cheaper source of financing than equity share capital. The more application of debt in the capital
structure brings down the overall capital, more particularly 100% application of debt finance leads to resemble the over all
cost of capital as cost of debt. The weighted average cost of capital will come down due to more application of leverage in
the capital structure, only with reference to cheaper cost of raising than the equity share capital cost.

• Ko = Ke (S/V)+Ki(B/V)

• Ko = Overall cost of capital

• Ke = Cost of Equity

• S = Market Value of Equity

• V= Value of Firm

• Ki= Cost of Debt

• B= Market Value of Debt

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 CONTD…

• The value of the firm is more in the case of lesser overall cost of capital due to more
application of leverage in the capital structure. The optimum capital structure is that at
when the value of the firm is highest and the overall cost of capital is lowest.

• V=B+S

• V= EBIT/Ko

• This approach highlights that the application of leverage influences the overall cost of
capital and that affects the value of the firm.

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 CONTD…

The degree of leverage is plotted along the X-axis whereas Ke, Kw and Kd are on the
Y-axis. It reveals that when the cheaper debt capital in the capital structure is
proportionately increased, the weighted average cost of capital, Kw, decreases and
consequently the cost of debt is Kd.

Thus, it is needless to say that the optimal capital structure is the minimum cost of
capital if financial leverage is one; in other words, the maximum application of debt
capital.

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 NET OPERATING INCOME APPROACH

• This another approach developed by Durand, which has underlying principle

that the application of leverage do not have any influence on the value of the
firm through the overall cost of capital. The more application of leverage leads
to bring down the explicit cost of capital on one side and on the other side
implicit cost of debt is expected to go up. How the implicit cost of debt will go
up? The more application of debt leads to increase the financial risk among the
investors, that warranted the equity share holders to bear additional financial
risk of the firm. Due to additional financial risk, the share holders are requiring
the firm to pay additional dividends over the existing. The increase in the
expectations of the shareholders with reference to dividends hiked the cost of
equity.

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 CONTD…
• Main Points:

 Under this approach, no capital structure is found to be a optimum capital structure. The major reason is that the
debt-equity ratio does not influence the cost of overall capital, which always nothing but remains constant.

 The overall capitalization rate of the firm Kw is constant for all degree of leverages.

 Net operating income is capitalized at an overall capitalization rate in order to have the total market value of the
firm.

 It is finally concluded that this approach highlights that application of leverage never makes an attempt to enhance
the value of the firm, in other words which is known as unaffected by the application of leverage.

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 CONTD…

 Thus, the value of the firm, V, is ascertained at overall cost of capital (Ko):

• V = EBIT/Ko (since both are constant and independent of leverage)

 The market value of the debt is then subtracted from the total market value in order to get the market
value of equity.

• S–V–T
 As the Cost of Debt is constant, the cost of equity will be

• Ke = EBIT – I/S

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 CONTD…

Under this approach, the most significant assumption is that the Kw is constant irrespective of
the degree of leverage. The segregation of debt and equity is not important here and the market
capitalises the value of the firm as a whole.
Thus, an increase in the use of apparently cheaper debt funds is offset exactly by the
corresponding increase in the equity- capitalisation rate. So, the weighted average Cost of
Capital Kw and Kd remain unchanged for all degrees of leverage. Needless to mention here that,
as the firm increases its degree of leverage, it becomes more risky proposition and investors are
to make some sacrifice by having a low P/E ratio.

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 TRADITIONAL APPROACH

• The traditional approach is known as intermediate approach in between the Net income approach and NOI
approach. The value of the firm and the cost of capital are affected by the NI approach but the assumptions
of the NOI approach are irrelevant.

• The cost of overall capital will come down due to the application cheaper source of financing viz Debt
financing to some extent, after certain usage, the application of debt will enhance the financial risk of the
firm, which will require the share holders to expect additional return nothing but is risk premium.

• The risk premium which is expected by the investors will enhance the overall cost of capital.

• The optimum capital structure "the marginal real cost of debt, defined to include both implicit and explicit
will be equal to the real cost of equity.

• For a debt-equity ratio before that level, the marginal cost of debt would be less than that of equity capital,
while beyond that level of leverage, the marginal real cost of debt would exceed that of equity

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 CONTD…

• Main Points

 The cost of debt capital, Kd, remains constant more or less up to a certain level
and thereafter rises.

 The cost of equity capital Ke, remains constant more or less or rises gradually
up to a certain level and thereafter increases rapidly.

 The average cost of capital, Kw, decreases up to a certain level remains

unchanged more or less and thereafter rises after attaining a certain level.

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 CONTD…

It is found from the above that the average cost curve is U-shaped. That is, at this stage
the cost of capital would be minimum which is expressed by the letter „A‟ in the graph. If
we draw a perpendicular to the X-axis, the same will indicate the optimum capital
structure for the firm.
Thus, the traditional position implies that the cost of capital is not independent of the
capital structure of the firm and that there is an optimal capital structure. At that optimal
structure, the marginal real cost of debt (explicit and implicit) is the same as the marginal
real cost of equity in equilibrium.
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 MODIGLIANI-MILLER APPROACH

• It is the approach, attempts to explain the application of leverage does not have any influence on the
value of the firm through behavioral pattern of the investors. The behavioral pattern of the investors
is taken into consideration for explaining the value of the firm which is unaffected by the application
of debt/leverage in the capital structure through arbitrage process. The MM approach has three
different propositions:

(i) The overall capital structure of the firm is unaffected by the cost of capital an degree of leverage

• (ii) The cost of equity goes up and offset the increase of leverage in the capital structure

• (iii) The cut off rate for the investment purposes is totally independent.

• For discussion, the proposition is only considered for the study of usage of leverage in the capital
structure, which do not have any impact in the value of the firm.

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 ASSUMPTIONS OF MM APPROACH

The MM proposition is based on the following assumptions:

(a) Existence of Perfect Capital Market It includes:

(i) There is no transaction cost;
(ii) Flotation costs are neglected;
(iii) No investor can affect the market price of shares;
(iv) Information is available to all without cost;
(v) Investors are free to purchase and sale securities.

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 CONTD…

(b) Homogeneous Risk Class/Equivalent Risk Class:

• It means that the expected yield/return have the identical risk factor i.e., business risk is equal among all firms
having equivalent operational condition.

(c) Homogeneous Expectation:

• All the investors should have identical estimate about the future rate of earnings of each firm.

(d) The Dividend pay-out Ratio is 100%:

• It means that the firm must distribute all its earnings in the form of dividend among the shareholders/investors, and

(e) Taxes do not exist:

• That is, there will be no corporate tax effect (although this was removed at a subsequent date).

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 CRITICISM OF MM HYPOTHESIS

(i) Existence of Transaction Cost

(ii) Assumption of borrowing and lending by the firms and the

individual at the same rate of interest

(iii) Institutional Restriction

(iv) “Personal or home-made leverage” is not the prefect

substitute for “corporate leverage.”

(v) Incorporation of Corporate Taxes

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 MM HYPOTHESIS WITH CAPITAL
STRUCTURE AND CORPORATE TAXES
• The MM Hypothesis is valid if there is perfect market condition. But, in the real world capital
market, imperfection arises in the capital structure of a firm which affects the valuation.
Because, presence of taxes invites imperfection.

• If debt capital is used in the total capital structure, the total income available for equity
shareholders and/or debt holders will be more. In other words, the levered firm will have a
higher value than the unlevered firm for this purpose, or, it can alternatively be stated that the
value of the levered firm will exceed the unlevered firm by an amount equal to debt
multiplied by the rate of tax.

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 CONCLUSION

• Capital Structure refers to the make up of a firm‟s

capitalization. It represents the mix of different sources of
long-term funds such as equity shares, preference shares, long-
term loans, retained earnings, etc. in the total capitalization of
the firm.

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